Edited version of your written advice

Authorisation Number: 1051275017607

Date of advice: 30 August 2017

Ruling

Subject: Assessable income vs capital gain

Question 1:

Will the $XXX,XXX payment you will receive from Company A be assessable under either sections 6-5 or 15-2 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer:

Yes.

Question 2:

Will the $XXX,XXX payment you receive from Company A be assessable under Parts 3-1 or 3-3 of the ITAA 1997?

Answer:

Yes. However, section 118-20 of the ITAA 1997 will apply to reduce the capital gain to the extent that the $XXX,XXX is otherwise included as assessable income under either sections 6-5 or 15-2 of the ITAA 1997.

This ruling applies for the following period

Income year ending 30 June 2018.

The scheme commences on

1 July 2017.

Relevant facts and circumstances

After 20 September 1985, you entered into an employment agreement (EA) with Company A which contained the following:

● you agreed to receive a specified amount of salary (inclusive of superannuation and motor vehicle) and which included all entitlements to overtime, weekend, public holidays and leave loading and any other form of salary, loading or allowance to which you may otherwise be entitled under any award, agreement or other instrument applicable to your employment, and compensation for all service by way of overtime or attendance at events outside the standard hours of work;

● while you are employed by Company A you must notify the board of Company A (the Board) immediately you become aware of any matter which may give rise to an actual or perceived conflict of interest in relation to your position and any actual or perceived conflict of interest is to be resolved by mutual agreement;

● you agreed that you would inform the Board of any matter which may come to your notice during your employment which may be of interest or of any importance or use to Company A or any of its related entities and that you would communicate to the Board any proposals or suggestions occurring to you during your employment which may be of service for the furtherance of Company A’s business or the business of the related entities;

● any discovery, design, invention, idea, concept, technique, secret process or improvement in procedure conceived, made, developed or discovered by you while in the service of Company A or a related entity (whether alone or with any other person and whether or not during your normal working hours) which is capable of being used or adapted for use in connection with Company A’s business or the business of a related entity (“Inventions”) must be disclosed to the Board, whether or not the Inventions are capable of being protected by copyright, letters patent, registered design or other protection: and

● you will assign your entire right, title and interest in and to the Inventions (and any intellectual property obtained in respect of the Inventions) to Company A as the Board may nominate for the purpose.

You commenced your employment with Company A shortly after you had entered into the EA and undertook the following activities:

● managing the day to day operations of Company A’s business, its people and resources;

● developing and implementing the strategy approved by the Board and ensuring that Company A’s business structure and processes met the needs of their business;

● developing and recommending business plans for the Board’s consideration:

● submitting reports, budgets and financial statements to the Board;

● implementing all approved plans, policies and programmes and achieve agreed targets;

● overseeing the financial management of Company A’s business and implementing adequate operational planning and financial control systems;

● maintaining awareness of Company A’s business and economic environment as it affected their business;

● overseeing the effective operation, administration and development of Company A; and

● ensuring compliance with legal and regulatory obligations.

After an extended period after you had commenced your employment with Company A, you developed written concept plans (the Concept Plans) for a “new business” (the Business). You continued to develop and refine the Concept Plans over a significant period of time.

The Business:

● would sell specified products, supplies and services which would be developed further when the Concept Plans were implemented;

● would be operated out of leaseholds located in malls in contrast to Company A’s operations; and

● has the potential to generate significant financial returns with relatively low capital investment.

If the Concept Plans proved viable, you anticipated developing them into a separate operating business outside of Company A’s operations.

The Concept Plans are not registered at this point as they are still at concept stage.

You informed Company A of the Concept Plans who conducted a review of them. After deliberations, Company A determined that it would not undertake any further assessment of the Concept Plans.

Following Company A’s decision not to proceed with the Concept Plans, you contended that as you owned the rights to them that you could exploit them for your own benefit.

Company A obtained legal advice about the ownership of the Concept Plans, and after receiving the legal advice has decided to purchase the Concept Plans from you.

The directors of Company A have negotiated to pay you an agreed amount of $XXX,XXX, being a once only payment to cover all current and future intellectual property, if any, to ensure that Company A has the legal interest in any such property.

A draft Deed of Assignment (Draft Deed) has been prepared in which you are named as the Assignor and Company A is named as the Assignee. The following information has been sourced from the Draft Deed:

● you will assign all of your rights title and interests in and to the Intellectual Property and all of your rights and interests in any goodwill in the Intellectual Property; and

● Company A will pay you the agreed price of $XXX,XXX.

A copy of the Concept Plans was attached to the Draft Deed which outlines the Business concept.

You are not in the business of developing and selling new businesses/concept plans.

You did not incur any expenses while developing the Concept Plans or during the negotiations with Company A.

Company A is amending your EA to ensure that if this issue arises in the future that it will be the owner of any ideas/concepts, etc. that you may develop/create, etc. in the future.

At this point:

● you have not signed the draft Deed of Assignment; and

● you have not attempted to sell the Concept Plans to any other party.

Assumptions

This ruling decision has been made on the assumption that the $XXX,XXX (or another amount) will be paid to you in accordance with the terms and conditions as outlined in the Draft Deed, and that those terms and conditions will not be changed in anyway other than in relation to the potential change of the amount being paid to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 15-2

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1936 Paragraph 26(e)

Fringe Benefits Tax Assessment Act Subsection 136(1)

Reasons for decision

Before the introduction of fringe benefits tax (FBT), the taxation of cash and non-cash fringe benefits was mainly governed by former paragraph 26(e) of the Income Tax Assessment Act 1936 (ITAA 1936) which provides for the inclusion in a taxpayer's assessable income of all allowances, gratuities, compensations, benefits, bonuses and premiums provided to the taxpayer which relate directly or indirectly to the taxpayer's employment or to services rendered by the taxpayer.

Section 15-2 of the ITAA 1997 is the rewritten provision, with equivalent meaning, of the former paragraph 26(e) of the ITAA 1936, which operated from 14 September 2006 and paragraph 26(e) of the ITAA 1936 ceased to have effect from the same date.

Section 15-2 of the ITAA 1997 does not apply if an amount is assessable as ordinary income under section 6-5 of the ITAA 1997.

Section 6-5 of the ITAA 1997

Section 6-5 of the ITAA 1997 provides that your assessable income includes income according to ordinary concepts, which is called ‘ordinary income’.

The legislation does not provide guidance on the meaning of 'income according to ordinary concepts' in section 6-5 of the ITAA 1997. However, guidance in determining whether a receipt will be ordinary income can be found in case law.

In Scott v. Commissioner of Taxation (NSW) (1935) 35 SR (NSW) 215, Jordan CJ held that the meaning of ‘income’ was to be determined according to ‘ordinary concept and usages’ at 219 as follows:

The word “income” is not a term of art, and what forms of receipts are comprehended within it, and what principles are to be applied to ascertain how much of those receipts ought to be treated as income, must be determined in accordance with the ordinary concepts and usages of mankind, except in so far as the statute states or indicates an intention that receipts which are not income in ordinary parlance are to be treated as income, or that special rules are to be applied for arriving at the taxable amount of such receipts: A.-G. for British Columbia v. Ostrum ([1904] AC 144 at 147); Lambe v. Inland Revenue Commissioners ([1934] 1 KB 178 at 182-3).

Ordinary income will generally have the characteristics of being periodic, recurring, and regular. Such characteristics of income have been emphasised by decisions in the Dixon case and Just v. FC of T (1949) 8 ATD 419. As Dixon CJ and Williams J stated in their decision in the Dixon case:

Because the £104 was an expected periodical payment arising out of circumstances which attended the war service undertaken by the taxpayer and because it formed part of the receipts upon which he depended for the regular expenditure upon himself and his dependants and was paid to him for that purpose, it appears to us to have the character of income…

In Brown v. Federal Commissioner of Taxation (2002) ATC 4273 (Brown case), the taxpayer, a former government minister, introduced the principal of a development company, Monacorp, to the principals of a large Japanese development company which was interested in purchasing land in Australia that Monacorp owned. In addition to the introduction of the two parties, the taxpayer also assisted in facilitating certain aspects of the transaction. Following successful completion of the transaction, the taxpayer received a home unit in lieu of a $670,000 cash commission which was purported to be a gift.

The Full Federal Court held the benefit realised by the taxpayer in this case involved more than mere gratitude. The benefit realised was directly related to the services provided to facilitate the transaction between the parties. As the benefit received by the taxpayer was dependent on the transaction between the parties proceeding, the inference could be made that the taxpayer’s activities to facilitate the transaction to assist its completion also played a part in the provision of benefits to him. Therefore the benefit the taxpayer received, in the form of property, was assessable under paragraph 26(e) of the ITAA 1936.

However, a one-off payment may also be characterised as ordinary income where the payment has a sufficient connection with services rendered. This has been supported by decisions in Reuter v. FC of T 93 ATC 4037; (1993) 111 ALR 716 at ATC 4047; ALR 730 (Reuter case).

In the Reuter case, the taxpayer, an accountant, was approached by a merchant bank to advise on a corporate takeover involving two companies. Following the subsequent stock market crash of October 1977, the merchant bank obtained a credit line facility from another company, secured by the fee arrangement of the corporate takeover, from which the taxpayer was paid $8 million. This payment also saw that the taxpayer would relinquish any previous claims to proceeds from the corporate takeover as originally agreed.

During appeal, the court held that regardless of whether the right to receive income was relinquished, the amount received was directly connected with the services provided by the taxpayer and that the payment was a product of the services provided to the merchant bank. As Hill J said at ATC 4047; ALR 730:

Perhaps the most usual usage of the word `income' in ordinary speech is to describe that which comes in as a reward for services. Amounts such as salary, wages, commission, tips and the like, are universally regarded as income and it is immaterial whether they are paid under or pursuant to a contract of service or services on the one hand, or gratuitously on the other. So, too, for income tax purposes, it would be immaterial whether an amount which is a reward for services is paid to the taxpayer in advance of the services being performed (eg, a signing-on fee) or after the services have been performed, or whether the payment is made by the person for whom the services are performed or by some other person. It will also be generally immaterial whether the amount paid is paid periodically or in a lump sum. What will matter is the character of the payment as a reward for services or, as it was put by Fullagar J in Hayes v FC of T (1956) 11 ATD 68 at 74; (1956) 96 CLR 47 at 57-58, whether the receipt is a `product' of the taxpayer's services.

Section 15-2 of the ITAA 1997

The courts have consistently indicated that paragraph 26(e) of the ITAA 1936 was not limited to employment situations and that it can apply to payments for services rendered in the absence of an employer/employee relationship.

Section 15-2 of the ITAA 1997 equivalent of paragraph 26(e) of ITAA 1936 and cases concerning paragraph 26(e) of the ITAA 1936 will continue to be relevant in considering the application of section 15-2 of the ITAA 1997.

Section 15-2 of the ITAA 1997 is relevant in the context of benefits etc provided in respect of or in relation to:

● employment; or

● services rendered.

With respect to the applicability of this provision, the critical issue to be considered in this case is whether there was a direct or indirect connection between the payment you received and the services you provided your employer.

Directly or indirectly related to employment

The phrase ‘in respect of’ in relation to the employment of an employee is defined in subsection 136(1) of the Fringe Benefits Tax Assessment Act to include ‘by reason of, by virtue of, for or in relation directly or indirectly to, that employment’.

The meaning of this phrase was considered by the Federal Court in J & G Knowles v. Federal Commissioner of Taxation [2002] 96 FCR 402; 2000 ATC 4151; 44 ATR 22 (Knowles case) and Starrim Pty Ltd v. Federal Commissioner of Taxation [2000] FCA 952; 2000 ATC 4460; 44 ATR 487 (Starrim case).

In Knowles case the Full Federal Court considered the judgements in Smith v. FCT (1987) 164 CLR 513; 19 ATR 274; 87 ATC 4883 and Federal Commissioner of Taxation v. Rowe (1995) 60 FCR 99; 31 ATR 392; 95 ATC 4691 before concluding that it is not sufficient for the purposes of the FBTAA to conclude that there is a causal connection between the benefit and the employment.

At paragraph 26 the Court said:

Whatever question is to be asked, it must be remembered that what must be established is whether there is a sufficient or material, rather than a, causal connection or relationship between the benefit and the employment

At paragraphs 28 and 29, the Court said:

While the width of the definition of “fringe benefit” was designed to capture benefits that, in truth, were other than remuneration, the stated purpose suggests that asking whether the benefit is a product or incident of the employment will be helpful. If it is not then the benefit is likely to be extraneous to the employment and will not bear FBT, notwithstanding that the employment might have been a causal factor in the provision of the benefit. In particular, the fact that a benefit is provided to a director because it was authorised by that director will not, of itself, be sufficient to characterise the benefit as one which is “in respect of” the employment. Without more, it is not a product of incident of that office.

To put the matter another way, although the process of characterising the benefit provided in a particular case can involve questions of fact and degree, it is not sufficient for the purposes of the FBTAA merely to enquire whether there is some causal connection between the benefit and the employment: see FCT v Rowe (1995) 60 FCR 99 at 114 and 123; 31 ATR 392 at 404 and 412; 95 ATC 4691 at 4703 and 4710. Although Brennan, Deane and Gaudron JJ observed in Technical Products (at 47), that the requisite connection will not exist unless there is “some discernible and rational link” between the 2 subject matters which the statute requires to be linked, as was pointed out by Dawson J (at 51), the connection must be “material”.

In Starrim Lindgren J. further considered the phrase ‘in respect of’ in relation to a private company which provided benefits to a husband and wife who were its only shareholders and directors. In considering whether the benefits were provided in respect of their employment as directors, Lindgren J said at paragraph 52:

Fourthly, the decision of the full court in Knowles establishes that the required relationship between the provision of a benefit and the employment is not established merely by the existence of some or a causal relationship, and, in particular, that it is not established by nothing more that the fact that the employee has been able to cause the benefit to be provided to him by reason of his or her office as a director of the employer. There must be a “sufficient” or “material” relationship between the employment and the provision of the benefit.

In relation to paragraph 26(e) of the ITAA 1936, the leading case is FC of T v Dixon (1952) 86 CLR 540: 10 ATD 82 (Dixon case). In that case, it was held that weekly instalments to make up the difference between the rate of civil pay of an employee on enlistment and the rate of his defence force pay was in the nature of income, and therefore assessable. However, all the members of the High Court agreed that the payments were not allowed, given or granted to the employee in respect of, or for, or in relation directly or indirectly to any employment of or services rendered by him within the meaning of paragraph 26(e) of the ITAA 1936.In a joint judgment Dixon CJ and Williams J held at CLR 553 and 554 that:

A direct relation may be regarded as one where the employment is proximate cause of the payment, [whereas] an indirect relation is one where the employment is a cause less proximate, or, indeed, only one contributory cause.

The closer the benefit or gain is to the workplace or employment, the more likely it is to be ordinary income (or be subject to fringe benefits tax). In Federal Commissioner of Taxation v. Smith (1986) 86 ATC 4463 (Smith case), a taxpayer received a payment for completing a management certificate course. Once the court accepted that the payment would not have been made if the relationship of employer and employee had not existed, it was impossible to deny that employment was not a contributory cause of the payment. The payment was therefore causally connected to the taxpayer's employment by the bank and was assessable under paragraph 26(e) of the ITAA 1936.

Services rendered

The expression "services rendered" refers to situations not encompassed by the term "employment". "Services rendered" was considered in FC of T v Holmes 95 ATC 4476 (Holmes case) where the taxpayer, a marine engineer on an anchor tug and supply vessel, was involved in the rescue and salvage of an oil tanker that was drifting to shore. As a result, the taxpayer and other mariners involved in the successful rescue of the oil tanker received a pro rata distribution according to their salary entitlements.

The court held that although the obligation to make the payment to the taxpayer was contingent upon the success of the salvage operation there was a real connection between the payment received by the taxpayer and the services rendered by him in the course of the salvage operation. The payment was a reward for the services rendered by the taxpayer and fell squarely within the language of paragraph 26(e) of the ITAA 1936.

In FC of T v Cooke & Sherden 80 ATC 4140, the taxpayers carried on business as home delivery soft drink retailers. They purchased the drinks from the manufacturers and then resold them to householders in allocated districts. As an incentive, the manufacturers operated a free holiday scheme under which non-transferable holidays were provided to the taxpayer, which could not be converted into cash. The benefit of the holidays was tax free in the retailers' hands. The benefit was not assessable under former s 26(e) because the taxpayers had not rendered services to the manufacturers in the relevant sense. The retailers conducted their businesses for their own benefit, and the advantages which thereby accrued to the manufacturers were not the product of services rendered to the manufacturers.

In Brent v FCT (1971) 125 CLR 418; 2 ATR 563, the wife of Ronald Biggs (the Great Train Robber) agreed to sell her story to a newspaper for $65,250, payable in 3 instalments. She received $10,000 on signing the contract, but was not paid the final 2 instalments (apparently because she did not request payment). The Commissioner assessed the taxpayer on $65,250. The taxpayer argued that she was not providing personal services but was simply parting with a capital asset (her “knowledge”). The High Court held that the taxpayer was assessable on the $10,000 as it was a payment for personal services rendered (eg in making herself available for interview and in communicating information). However, the unpaid amount was not assessable because it had not been dealt with on the taxpayer's behalf

Capital gains tax

The capital gains tax (CGT) provisions are contained in Parts 3-1 and 3-3 of the ITAA 1997. Broadly, the provisions include in your assessable income any assessable gain or loss made when a CGT event happens to a CGT asset that you own.

CGT event A1 happens if you dispose a CGT asset. A CGT asset is any kind of property or a legal or equitable right that is not property.

CGT event D1 happens if you create a contractual right, or other legal or equitable right in another entity.

A CGT asset is:

● any kind of property; or

● a legal or equitable right that is not property.

While A CGT event A1 will still occur as a result of the disposal of a CGT asset, section 118-20 of the ITAA 1997 operates to ensure that amounts which are assessable income outside of the CGT provisions are not also taxed as capital gains.

Therefore, while CGT event A1 will occur when an asset is sold, any capital gain will be reduced by the amount included as ordinary assessable income under another provision. The inclusion of the profit or gain on the sale of a CGT asset as ordinary income does not mean that a CGT event does not happen in relation to the asset.

Application to your situation

After 20 September 1985, you commenced your employment with Company A.

You developed the Concept Plans and informed Company A of them. Company A determined that it would not proceed with the Concept Plans and you decided that you wanted to exploit them.

It is stated that Company A obtained legal advice in relation to the Concept Plans and now wants to purchase the Concept Plans from you as they may potentially be synergistic with its homewares business.

You and the directors of Company A have agreed on an amount of $XXX,XXX, being a once only payment to cover all current Concept Plans and any future intellectual property to ensure that Company A has the legal interest in any such property.

A draft Deed of Assignment has been prepared in relation to the sale of the Concept Plans to Company A for $XXX,XXX, but at this point has not been signed.

When making our decision on how the $XXX,XXX payment (the Payment) will be assessed, we have made the following observations:

● The EA you entered into with Company A outlines:

● that you will receive a specified amount of salary which is inclusive of all entitlements to overtime, weekend, public holidays and leave loading. It does not specify your hours of employment;

● you are required to communicate to Company A’s Board any proposals or suggestions that occur to you during your employment that may be used in the furtherance of Company A’s business or a related entities business;

● any discovery, design, invention, idea, concept, technique or improvement in procedure that you conceived, made, developed or discovered while in Company A’s service, or a related entity, whether by yourself or with any other person and whether or not it was during your normal working hours, which was capable of being used or adapted for use in connection with Company A’s or a related entity (Invention) must be disclosed to the Board; and

● you will assign your right, title and interest in and to all Inventions to Company A as nominated by the Board.

● the coming up with ideas, concepts, plans, etc. (future rights) would appear to be consistent with the duties contained under the EA for you to be creative in enhancing the furtherance of Company A or a related entities’ business. This is supported by the statement provided in the ruling that it is your role to undertake activities in relation to the developing and recommending of business plans for the Board’s consideration;

● The Business would sell products which would appear to be similar to the products that Company A is selling;

● the Payment is being made by your employer;

● it is stated that the Payment will be a one off payment to cover any current or future concepts, ideas, etc. that you may come up with so that Company A and its related entities will have the ownership interest in those Inventions; and

● your current EA is being amended to account for this type of issue occurring in the future so that Company A will have the ownership interest in any future Inventions.

Based on the information and documentation provided it is viewed that the payment of the $XXX,XXX is being made as a result of your employment with Company A and its receipt could be viewed as a product of that employment given that it is payment for the Concept Plans (current intellectual property), and any future ideas, concepts, etc. (future intellectual property), that you may come up with in the future during your employment with Company A.

There is a clear connection between your employment with Company A and the payment as it relates directly to your employment and your employment is a contributory cause of the payment.

Therefore, payment will be as a consequence of the employer-employee relationship you have with Company A, and will be in respect of your employment. Your employment with Company A is not only a contributory cause, but a proximate cause for the payment of the $XXX,XXX to you.

It is therefore considered that the $XXX,XXX you receive from Company A for the Concept Plans will be assessable under section 6-5 of the ITAA 1997 or section 15-2 of the ITAA 1997.

The basic CGT provisions will still apply even if the calculation results in there being no capital gain or loss, or the capital gain or capital loss being disregarded in accordance with section 118-20 of the ITAA 1997.

In this case, under the CGT provisions there are two CGT assets being:

● the Concept Plans that you developed; and

● the right to exploit any plan, concept, idea, etc. (future rights) that you may develop in the future.

A CGT event A1 will occur on the disposal of the Concept Plans to Company A and a CGT event D1 will occur when you grant Company A the right to exploit any future rights.

Therefore, any capital gain or capital loss will still need to be calculated for both CGT events. Section 118-20 of the ITAA 1997 will reduce any capital gain made on the sale of the Concept Plans to the extent that payment will be assessed under another provision.

While the EA generates a number of rights that you may hold as CGT assets, the exploitation of those CGT assets will still be viewed as being in relation to your employment with Company A and will be assessable under either section 6-5 of the ITAA, or section 15-2 of the ITAA 1997.

It is unnecessary to determine whether section 6-5 of the ITAA 1997 or section 15-2 of the ITAA 1997 should take preference because there is no disagreement between these two sections concerning the assessability of the $XXX,XXX and the financial year in which the Payment should be included.

Therefore, the $XXX,XXX will be included in your assessable income in the income year in which it is received as ordinary income under section 6-5 of the ITAA 1997, or alternatively under section 15-2 of the ITAA 1997.

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